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Thursday, September 2, 2010

Bernanke Confronts "Too Big to Fail"

In recent testimony before the Financial Crisis Inquiry Commission, Fed Chairman Ben Bernanke confronted the "too-big-to-fail" problem head on. "If the crisis has a single lesson," he said, "it is that the too-big-to-fail problem must be resolved."

How did the US banking system get into this position? It used to be known as a system of small banks, and there are still nearly 4,000 community banks with assets under $100 million. However, most of the growth of banking in recent years has come from large, multi-bank holding companies. According to FDIC data, the 105 banks with more than $100 billion in assets hold 78 percent of all bank assets. Even more striking, just four banks, each with $1 trillion or more in assets, control 58% of all bank assets.

A bank is too big to fail if its failure would threaten the function of the whole banking system via losses to uninsured depositors, losses to counterparties on complex transactions, and general fear of dealing with all banks when even the largest are seen as vulnerable. When banks become aware that they are protected from to failure, they become subject to the problem of moral hazard. Knowing they will be bailed out when they get in trouble, they take too many risks. Confident of bailouts, investors, in turn, supply capital to the biggest banks at favorable rates, so the big grow ever bigger.

What can be done? One solution would be to break up the biggest banks into smaller institutions. Such measures were discussed, but rejected, during recent discussions of financial reform. Instead, the 2010 Dodd-Frank Act took a different approach. It attempted to eliminate moral hazard by instituting a new resolution mechanism for complex banking organizations that would allow even the largest institutions to be wound up without bailouts of management, shareholders, or counterparties.

Will it work? It all depends on credibility. "Simple declarations that the government will not assist firms in the future . . . will not be credible on their own," Bernanke said in his recent remarks. Declarations of intent need to be backed up not just by Dodd-Frank type resolution mechanisms, but by other measures as well, such as the stronger capital requirements expected under the forthcoming Basel III agreements.

Ultimately, though, we will not know if the new measures will work until they are tested. We will find out only when the next crisis strikes.

Follow this link to download a free set of classroom-ready slides discussing the too-big-to-fail problem.

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